- choose "DDS" for DXT output in the dropdown
- pick the game folder with the MONKEY1.PAK file in it as Destination Folder
- and save the file with "Include original subfolder" checked

... it will store the file in the same subfolder that the game expects to find it in - but in dds format, which a lot of graphics apps and image converters can open (there's a plugin for e.g. PhotoShop, I believe).

Then, after you've edited the DDS, it needs to be converted back to DXT format - jott posted a tool for that above - and should stay in the same folder, with the same name (but with .dxt extension).